THE Bank of International Settlements (BIS) has issued yet another stark warning that lessons have not been learnt from the financial crash.
There were several stages of that financial crash that climaxed in the final quarter of 2008 and early 2009. Ten years ago, there was a run and then a total collapse of the British bank Northern Rock. The capital of most banks has increased since then. The BIS, the central banks’ central bank, xontends, however that the financial system could be vulnerable to an unexpected rise in inflation followed by a sudden rise in short and long-term interest rates.
Many sanguine fund managers and bond and equity traders have tended to ignore the BIS, as it has a reputation for being conservative and has issued warnings for some time. The latest September report of the BIS, however, indicates that it would be unwise to ignore several disturbing signals.
“Signs of increased risk-taking have become apparent in a number of areas, including narrow credit spreads, increased carry trade activity and looser bond covenants,” cautions the BIS. “As is typical for periods of low volatility and a falling dollar, a ‘risk-on’ phase (has) prevailed.”
Emerging market equity and bond funds have experienced large inflows. Speculative positions point to “broader carry trade activity: large net short positions in funding currencies, such as the yen and Swiss franc, and large net long positions in emerging currencies and the Australian dollar”.
The BIS adds that equity market investors have also employed record amounts of margin debt to lever up their investments.
“In fact, margin debt outstanding is substantially higher than during the dotcom boom (of 1999 to 2000) and is around 10 per cent higher than its previous peak in 2015.”
High PE and cyclically adjusted PE’s (the CAPE ratio) indicate that equity valuations are “stretched”. Bond yields are well below historical averages in the US and Europe, suggesting that “equity markets continue to be vulnerable to the risk of a snapback in bond markets”.
The BIS’s concerns also include the following:
- The outstanding stock of securities issued by banks grew at its fastest pace in six years in the first half of 2017, rising to a whopping US$22.7 trillion.
- The global volume of outstanding leveraged loans, as recorded by S&P Global Market Intelligence, reached new highs of more than US$1 trillion. At the same time, the share of issues with “covenant-lite features” or inadequate security, increased to nearly 75 per cent from 65 per cent a year earlier. According to Moody’s, the covenant quality declined to the lowest levels since 2011 when the rating agency began to record these numbers. The general health of corporate balance sheets has also deteriorated.
- Outstanding government debt of emerging market economies since 2007 jumped to US$11.7 trillion at end-2016, while government debt rose by 10 per cent to 51per cent of GDP over the same period. Brazil, China and India accounted for around US$8 trillion of this amount.
- The off-balance sheet dollars owed by non-banks outside the US may exceed their US$10.7 trillion of on balance sheet dollar debt. The missing debt is secured with foreign currency and is mostly short-term. It is likely to generally serve as a hedge for foreign exchange. But rolling over short-term hedges of long-term assets can still spark or amplify funding and liquidity problems during periods of stress.
© Copyright Neil Behrmann
This article was first published in The Business Times, Singapore
Jack of Diamonds, the sequel to Trader Jack- The Story of Jack Miner will be published in early this year. Neil is also author of anti-war children’s novel Butterfly Battle- The Story of the Great Insect War. The updated 2015 Waterloo commemoration version of Butterfly Battle is on Kindle and e-books. Reviews are on neilbehrmann.net and Amazon and more reviews are welcome. If the books are purchased direct on this site, a proportion of the proceeds will go to low cost charities